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The Odds Are Changing - Audits of Flow-Through Entities

For years, the collective wisdom has been that flow-through entities such as partnerships and S corporations are rarely audited. We still regularly hear that comment in the marketplace. However, this is no longer the case. In fact, several years ago the IRS identified high-wealth individuals as an area of audit emphasis, and the partnerships in which many of these individuals invest have also come under additional scrutiny. At a time when the IRS appears to have entered an increasingly aggressive audit cycle, a recent series of high-profile IRS-favorable court decisions, such as Canal, Reddam and Blum, have the potential to further embolden the IRS. In all three of these cases, the judges' opinions were particularly critical of all parties involved, and the IRS assessed the maximum penalties available even though the taxpayers had relied on formal opinions from the Big 4 accounting firms that prepared their tax returns. Taxand US discusses the impact that the results of these court cases may have on subsequent decisions and how this may affect US businesses.

While one may understand the hard line the IRS has taken on transactions it considers particularly abusive, this hardline approach is not always limited to audits of similar transactions. In particular, our practice has noticed that audits of wealthy individuals have taken on a more confrontational tone from the outset. The IRS's recent approach seems to apply the same skeptical manner with which it approached the OPIS (offshore portfolio investment strategy) transactions in Reddam and Blum and the highly structured real estate gain deferral transaction in Canal to client-specific routine tax planning. An offshoot of this attitude, among other things, seems to be a willingness to assess penalties much more frequently than in the past.

Taxand's Take

Based on published statistics on audits of high-net-worth individuals and our experience, income tax audits are on the rise. Given the current political climate and the prevailing mood within the IRS, it is our guess that audits of high-wealth individuals and flow-through entities will continue to rise in the near term and that more and more of these audits will not be resolved at the examination level for the reasons outlined above. As a result, we recommend that clients analyse their documentation procedures in order to be well prepared when the time comes to defend their tax positions. As has always been the case, and perhaps increasingly so today, the best way to control the audit process is to be prepared with as much documentation as possible from the outset.